by Jack Waymire
Arguably, one of the biggest fears when considering personal finance planning is Bernie Madoff, the infamous conman who bilked 11,000 investors out of $65 billion in the largest and most damaging Ponzi scheme in history. Could I too be taken advantage of by someone like him? Is my advisor telling me the truth?
When Madoff was arrested in December 2008, he instantly became the face of the greed and corruption that had permeated Wall Street for decades. His image lingers years later and continues to haunt investors to this very day. He plead guilty to multiple counts of fraud, theft and money laundering and was sentenced to 150 years in prison. However, though he is now behind bars, a heightened sense of fear lingers when it comes to selecting an advisor and starting the journey of personal finance planning.
But here’s the sad and scary truth: Thousands of Madoff’s victims could have used the Internet to avoid the biggest investment scam in U.S. history. We want to show you how you can avoid it too. Personal finance planning doesn’t have to be scary. You just need to do the proper research to make sure you’re working smart and safe.
We can all learn a lot by studying the Madoff story. A little extra work now can save a lifetime of misery.
1. Selecting a financial advisor is a business decision that should be based on an objective research process that is not impacted by the advisor’s sales skills.
First, let me say that Madoff’s clients were not stupid people. They had to accumulate a lot of assets just to afford his investment services. Plus, they were surrounded by tax, legal and financial specialists who were supposed to protect their interests.
But many of them made their decision to work with him simply on referrals and claims that they never verified.
On paper, Madoff founded one of the largest market makers on Wall Street. He served as the Chairman of the Board of Directors for the National Association of Securities Dealers (NASD), the then self-regulatory body for the securities industry. He was a member of the Board of Directors of the Securities Industry Association, which wielded a substantial amount of political power in Washington, D.C. He was a man people thought they could trust by virtue of his industry visibility, past accomplishments and sterling credentials.
He was also very charming. Like many of the best con-artists, he was an exceptional schmoozer with an uncanny ability to convince wealthy individuals that he had a unique process for investing their assets. Not only was he able to convince people that he could produce positive returns in all market conditions but he made them feel exceptionally lucky to be investing with him. One of the most frequent laments from his victims was, “I thought he was my friend.”
For that reason, no one dared question his methods or results because they were afraid he would drop them from his list of wealthy clientele. He even turned away some investors to create a sense of exclusivity, which made him even more alluring to the rich and famous. Although he guaranteed easy access to their funds, his clients were afraid to withdraw their money for fear of not being able to get back in.
When you are in the presence of a person with this amount of charisma, most people feel awkward even asking questions – they just hand over their money and hope he is as good as they say he is.
But that was a big mistake.
When searching for a financial advisor to handle your personal finance planning, an investor needs to make sure that person is who they say they are.
In the Madoff situation, investors’ selection process was nothing more than an act of faith. Many were referred to Madoff by someone they trusted, so there seemed to be no need to spend valuable time researching someone who appeared to have mastered the art of walking on water.
However, if they did, they would have found many red flags.
2. Always use the Internet to research advisors before you select them.
My first book, “Who’s Watching Your Money,” was published in 2003. The Paladin Registry website, which was based on the principles in the book, was launched in April 2004. It was the first online resource that educated investors about financial advisors and provided a registry of vetted, documented financial professionals and firms.
The day after Madoff’s arrest, Paladin’s advisor-research team utilized the Internet to vet Madoff and his firm. It took just 40 minutes to complete the research and the results clearly identified Madoff as a serious risk.
Imagine, 40 minutes could have saved 11,000 investors $50 billion.
Paladin’s due diligence on Madoff occurred after his arrest so we had to act quickly before law enforcement and the regulatory agencies shut down his website and online records at FINRA and the SEC.
In a matter of minutes using the Internet, Paladin was able to identify several red flags that should have warned investors about the legitimacy of Madoff’s investment claims and his business model.
The first step in personal finance planning should be a visit to the Financial Industry Regulatory Authority (FINRA) website, because it is here that you can view advisors’ record of compliance. In particular, you should look for any client complaints or disciplinary actions on their records. Complaints can be frivolous or serious, but any history of complaints should at least cause increased awareness.
Madoff was registered as a broker-dealer with the National Association of Securities Dealers (NASD), which later became FINRA. Although his Ponzi scheme was conducted through a separate, investment advisory company, he was still subject to FINRA regulations for his broker-dealer activities. His FINRA report did contain several violations involving his trading activities for which he was censured three times (twice for the same violation) over a nine-year period with total fines of $45,000. He also received 14 Cautionary Letters for technical and/or reporting violations.
While many of these violations appeared to be routine and were not related to his Ponzi scheme, when one person or firm has this many infractions, it is a warning to proceed with caution. From our perspective, any firm that breaks the rules in the past will break the rules in the future. FINRA data supports this conclusion, showing that advisors with one violation are 50 percent more likely to commit another violation at some point in the future.
The Securities and Exchange Commission (SEC) is another important place to visit when considering your personal finance planning. Madoff provided financial advice for a fee, so Paladin’s next Internet stop was the SEC’s website to review the firm’s Form ADV.
For many years, Madoff represented himself as a money manager, but he did not register with the SEC until 2006. That is a major violation that was overlooked by the regulatory agencies and it should have been a major red flag for anyone who was familiar with SEC requirements for money managers.
We also discovered that Madoff and his brother, Peter, were the only professionals listed at his firm. There was no chief investment officer, analysts, portfolio managers or other staff for a firm that said it was managing $17 billion. This should have been another major red flag for the regulatory agencies and investors.
All of this information, as well as much more that would cause some major red flags, was available on the Internet. Any prudent investor who had access to this information would have rejected Madoff’s sales pitch. Unfortunately, that is not what happened and the results were devastating.
3. A posh office and marketing hype is not a substitute for competence and ethics.
Madoff’s website was the next stop for Paladin’s research team. You can learn a lot about financial advisors on their websites based on what they do and do not tell you.
Madoff’s website was extraordinarily bad. Most of the information you expect to find on an advisor’s website was missing. Instead, there was a convoluted description of a derivatives-based “black box” investment strategy. The term “black box” refers to an investment strategy based on an algorithm that is supposed to be so complex that investors cannot possibly understand it. It became an act of faith that the “box” could produce the results that were claimed by Madoff.
Investors had to believe Madoff was smarter than everyone else for his scam to work.
4. An advisor’s investment process should make sense before you commit your assets.
Our last stop was the media.
We searched for online news articles about Madoff, using various search terms combined with the name “Madoff,” such as news, investigations, complaints, fraud and lawsuits. A few articles popped up that were additional cause for concern.
One article from 2001 caught our eye. The article questioned Madoff’s secretive strategy and how it earned double-digit returns for decades with virtually no negative months. What did Madoff know that thousands of other investment professionals did not know?
Hedge fund managers who were familiar with Madoff’s results also said his returns could not be replicated using several of their investment models. No one claimed Madoff was cooking the numbers, but there was speculation that he may have been front-running trades through his brokerage firm.
Another article we found interviewed more than a dozen investment experts who said they were baffled by the way Madoff was able to generate consistently positive returns regardless of market conditions.
While none of the articles alleged fraud, prudent investors should have taken notice and questioned whether they should invest in something they could not understand.
It’s fairly safe to say that, between new regulations and the strengthening of enforcement standards by both FINRA and the SEC, nothing on the scale of a Madoff scheme should happen again. However, each year, thousands of investors are impacted by smaller scams and millions more are impacted by bad financial advice.
If you have never been victimized by a scam, you might think it simply won’t happen to you – your advisor is a trustworthy financial expert, maybe even a friend. We hope you are right, but it still pays to use the Internet to verify information that is provided to you by advisors.
There are 11,000 Madoff victims who wished they had done that.
Jack Waymire worked in the financial services industry for 28 years before he left to found the Paladin Registry (www.PaladinRegistry.com) in 2004. This investor education website was based on the Principles in Jack’s first book: “Who’s Watching Your Money? The 17 Paladin Principles for Selecting a Financial Advisor.”
The Registry also has a free service that matches investors to advisors who meet Paladin’s minimum requirements for competence and trustworthiness.
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